On October 23, 2006, Berkshire Hathaway became the first American stock to trade above $100,000 per share. By the end of 2007, BRK reached $149,200, which gave Berkshire a market value of more than $200 billion. Berkshire was the world’s most respected company, according to a Barron’s survey.1 Buffett’s personal fortune exceeded $60 billion, and only a few months earlier, the Dow had reached its all-time high of 14,164.53.2 Businesses were posting record earnings; the market, as a discounting machine, built into stock prices the expectation that an even greater and growing stream of money could be coaxed from consumers’ pockets.
Buffett dampened his own shareholders’ expectations of Berkshire, yet showed no signs of giving up control or competing any less aggressively than before. Even so, a few of Berkshire’s longtime shareholders began to sell stock. Some were donating appreciated shares to charity at a recently run-up price. Others cited Buffett’s age; he was approaching seventy-eight. And inevitably, the $149,200 price tag for a single share of BRK drew in the sort of new investors who always buy in at the top.
As reflected in Berkshire’s stock price, Buffett had been enjoying a period of almost unbroken success since the end of the Internet bubble. Only one episode of any significance marred the record of these six years. This was a legal threat to Buffett and to Berkshire that, at least initially, was as serious as Buffett’s earlier encounter with the SEC over Blue Chip, and Salomon’s near brush with death. It had to do with General Re, Buffett’s onetime problem-child investment, which had—at least financially—undergone a remarkable recovery.
By 2007, the company had become the most successful of Berkshire’s long string of insurance turnarounds. After $2.3 billion of cumulative losses related to insurance and reinsurance sold in prior years, and $412 million of charges for the runoff of Gen Re Securities, the company’s derivatives unit, General Re was reporting the most profitable results in its history, with $2.2 billion of pretax operating earnings.3 It had earned back the losses and restored its balance sheet to a better condition than when Buffett bought it; it was operating with nearly one-third fewer employees and the company had been transformed.4
General Re had escaped the fate of Salomon and overcome the stigma of its Scarlet Letter. Buffett was finally able to praise it and its senior managers, Joe Brandon and Tad Montross, in some depth in his 2007 shareholder letter, saying “the luster of the company has been restored” by “doing first-class business in a first-class way.”5
But at the beginning of 2008, four employees of General Re and one employee of AIG were put on trial in Hartford, Connecticut, on charges of federal criminal conspiracy. For those on trial, the next few months would bring to a climax the years of hell that white-collar criminal investigations impose on their subjects. For Buffett, the trial would mean the beginning of the end to this particularly golden chapter of his life.
The trial came about as a consequence of General Re’s last act of ignominy before its change of management in 2001. General Re had created a Salomon-type scandal of its own in which it broke Buffett’s rule of not “losing reputation for the firm.” This was the event that had, as it unfolded, adjusted Buffett’s perception of the new legal-enforcement environment, in which showing extreme contrition and cooperation produced no advantage in how a company was treated by prosecutors. Extreme contrition and cooperation were now the expected minimum standard—in part because of Salomon. Anything short of that—for a company to defend itself or its employees, for example—could be considered grounds for indictment. Trying to exceed the minimum threshold for extreme contrition and cooperation, as Buffett was always inclined to do when confessing any sort of mistake or flaw, could even be a disadvantage now, attracting more attention to a company at a time when the fairness of certain state and federal criminal procedures was being questioned.6
General Re had first become entangled in legal and regulatory problems when New York Attorney General Eliot Spitzer started investigating the insurance industry over “finite” reinsurance in 2004. “Finite” reinsurance has been defined in many ways, but, put simply, it is a type of reinsurance used by the client mainly for financial or accounting reasons—either to bolster its capital or to improve the amount or timing of its earnings. While usually legal and sometimes legitimate, finite reinsurance had been subject to such widespread abuse that accounting rulemakers have spent decades trying to rein it in.*
In 2003, both General Re and Ajit Jain’s Berkshire Re were condemned in a special investigation for selling finite reinsurance that allegedly contributed to the 2001 collapse of an Australian insurer, HIH.7 Two years later, General Re was accused by insurance regulators and policyholders of having sold fraudulent reinsurance in the 1990s in connection with the failure of a Virginia medical malpractice insurer, the Reciprocal of America. Though the Department of Justice investigated the allegations extensively, no charges were brought against Gen Re or any of its employees.8 That same year, Eliot Spitzer’s investigation of the insurance industry prompted an additional investigation that concluded that six General Re employees had conspired with one AIG employee to aid and abet an accounting fraud for AIG. Before long, the New York State investigation was joined by the SEC and the Department of Justice.
In June 2005, two of the conspirators, Richard Napier and John Houldsworth, plea-bargained and agreed to testify for the prosecution against General Re’s former CEO, Ronald Ferguson; its former chief financial officer, Elizabeth Monrad; its head of finite reinsurance, Christopher Garand; and its general counsel, Robert Graham; as well as Christian Milton, head of reinsurance at AIG, all of whom were indicted on federal conspiracy and fraud charges. At the same time, the SEC and the Department of Justice began pursuing a settlement of some sort with Berkshire Hathaway.
The defendants were tried together as conspirators in a case that began in federal court in Hartford in January 2008 and lasted for several weeks. It was noteworthy for the prosecution’s use of numerous e-mails and taped telephone conversations in which several of the defendants had repeatedly discussed the matter in colorful terms. The fraud had been executed through a reinsurance transaction designed to deceive investors and Wall Street analysts by transferring $500 million in reserves to AIG to window-dress AIG’s balance sheet. This made AIG appear to have more claim reserves than it actually had, which soothed analysts’ worries that AIG might be overstating its earnings by failing to record sufficient expenses for claims. In fact, AIG was doing just that.
Spitzer, joined by the SEC and the Department of Justice, had investigated this question, and Munger, Tolles & Olson, led by partner Ron Olson, who sat on Berkshire’s board, had conducted a massive internal investigation at Berkshire Hathaway. The investigation, which subsequently expanded to include the AIG deal, focused mainly on General Re and its employees. Munger, Tolles was required to, in effect, act as an arm of the prosecution, and worked with the handicap of representing Berkshire Hathaway, General Re, and Buffett personally as its clients. The conflicts posed by this set of relationships were unusual, although not unheard of in the legal profession. Ordinarily Buffett would not tolerate, much less create, such a conflict-riddled situation, but the investigation terrified him and threatened his deeply ingrained desire for privacy.
Buffett thought of himself and Berkshire as indistinguishable. He had fought like a Rottweiler earlier in his career to escape being named in the consent decree to the Blue Chip fraud case. He was far more invested in his gargantuan reputation now, both psychologically and from a business standpoint. During the months in 2005 and 2006 that the investigation was at full boil, the threat to his reputation from the case obsessed him.
Buffett was put through an awkward investigative process by Munger, Tolles and interviewed by the government, but Spitzer was quick to clear him. In April 2005 (five months after he entered the race for governor of New York), Spitzer told George Stephanopolous on ABC This Week that Buffett was “only a witness.” He called Buffett an “icon” who had “succeeded in the right way” and who stood for “transparency and accountability.” One need not be a cynic to detect that Spitzer might have been angling for an endorsement from the Buffalo News in the governors’ race.9
After New York handed the criminal charges over to the Justice Department for prosecution, Buffett still remained in some jeopardy. If prosecutors could find enough evidence to indict Buffett, they would certainly do so. The question was, what is “enough”?
Contrary to the way they are often portrayed on television, modern prosecutors are not simply on a moral crusade trying to bring the guilty to justice; they are pragmatists who make strategic and tactical decisions. Faced with Warren Buffett, America’s icon of business ethics, the prosecutors churned through a unique calculus. There could be no greater prize for a prosecutor than to convict Warren Buffett; locking up Buffett could put a journeyman attorney on the road to the Supreme Court.
On the other hand, who would take the risk of prosecuting Warren Buffett and failing to convict him? If Buffett had been caught on videotape mugging and snatching a purse from a ninety-year-old lady, there was a pretty good chance a jury would decide that the tape was doctored, she was the mugger, and he deserved a medal—and he would walk. Not only that, prosecutors wanted Buffett as a potential witness because of the star power and credibility he would bring if he testified on their behalf.
In the end, Buffett was omitted from the government’s list of unindicted co-conspirators. Some believed that he received kid-glove treatment because of his status as an almost untouchable figure in business. Many in the insurance industry were infuriated because they felt Ferguson and the others were being treated unjustly, especially by comparison. Buffett was left wide open to such perceptions in part because Berkshire did not hire an outside law firm to conduct its internal investigation. Thus no matter how well MTO had performed its responsibilities, the appearance that the investigation was actually not independent was impossible to overcome.
In the trial, the defendants invoked a “Buffett defense,” saying that Buffett had approved the outlines of the structured transaction and was involved in setting the fee. The question, however, was not whether Buffett knew about the transaction—he did—but whether he knew it was fraudulent.
General Re’s CEO, Joseph Brandon, had been listed among the various unindicted co-conspirators in the case. He had received a “Wells Notice” (of possible civil fraud prosecution) from the SEC, although no civil charges were ever filed. He cooperated with federal prosecutors without asking for immunity. During the trial, Brandon was cited by the defendants’ lawyers as having knowledge of the deal; General Re’s chief operating officer, Tad Montross, was also named by the defendants as having knowledge of the transaction. In the end, none of the three men—Buffett, Brandon, or Montross—testified in the case.* After weeks in court and a short jury deliberation, in February 2008 all five defendants were convicted on all counts in the indictment and were sentenced to terms ranging from a year and a day (Robert Graham) to four years (Chris Milton of AIG). The convicted defendants said they would appeal.
In April 2008, shortly after the trial ended, Brandon resigned as CEO of General Re to help facilitate a settlement between the company and government authorities that has yet to take place. The settlement, when it comes, is likely to include fines, other penalties, and adverse publicity.*
Only a month after the jury reached its verdicts, New York Governor Eliot Spitzer resigned following revelations that he patronized the prostitutes of an escort service called the Emperor’s Club.
The Gen Re-AIG case he launched through his investigation was noteworthy in several respects. It is the only U.S. case in which financial reinsurance has resulted in criminal charges and prison sentences, rather than civil settlements. In recent corporate history, no other criminal aiding-and-abetting case has stuck; convictions in a Merrill Lynch case related to Enron were thrown out. For the first time, therefore, employees of one company were held responsible for a fraud committed by another company.
The Gen Re case also was one of the last corporate fraud cases prosecuted under the government policy of compelled waiver of the attorney-client privilege and the attorney work-product doctrine, which was revised after being declared unconstitutional by the U.S. District Court for the Southern District of New York. Thus, the defendants were arguably convicted using evidence that either would not have been available to prosecutors or would have been thrown out if the trial were held today.
Even though he was obsessed during this period with the investigation’s potential to harm his reputation, Buffett was able to compartmentalize the way he always did. Whenever a business opportunity presented itself, he’d shift with startling speed from anxious ruminant to hungry great white shark. Buffett was never more himself than when given the chance to invest in something he wanted at a price of his choosing.
With the stock market so expensive, for the past several years Buffett had continued to buy mostly whole businesses. Berkshire bought Iscar, a highly automated Israeli maker of metal cutting tools, in its first acquisition of a non-U.S. company. For Fruit of the Loom, Buffett bought Russell Athletics. Berkshire took control of Equitas, assuming the old claims of Lloyd’s of London in exchange for $7 billion worth of insurance float, and also bought electronics distributor TTI. Buffett invested steadily in the stock of BNSF (Burlington Northern Santa Fe) railroad in 2007, setting off a minor flurry of interest in railroad stocks. His interest in railroads was built on the thesis that U.S. imports from Asia, especially China, would continue to stay high—and the goods would have to be transported to markets all over the United States. Railroads have an advantage over trucking because of their greater fuel efficiency. The level of imports at the time he began buying this stock reflected a relatively weak dollar (compared to what came later) and a boom economy. As these conditions reversed, he stayed true to his long-term strategy; he would eventually increase Berkshire’s stake in BNSF to more than twenty percent of the railroad.
One investment that Buffett did not make was in the Wall Street Journal. Although it was his favorite newspaper, he had never owned its stock. When press lord Rupert Murdoch offered to buy the paper in 2007, some Journal editors and staffers hoped that Buffett would save it in the cause of quality journalism. But he would not pay a premium price for what he considered a rich man’s trophy, even to play a potentially historic role in media. Long ago, during the days of the Washington Monthly, the unsentimental side of Buffett had divorced his fondness for journalism from his wallet. Nothing had changed that.
In Buffett’s lifetime, the rapid “disintermediation” of the entirety of traditional media—that is, the replacement, at varying speeds, of recorded music, movies, newspapers, radio, television, and magazines by a single medium, consisting of the Internet and various hard storage devices such as the personal computer and the iPod—was the greatest change in business that he had ever witnessed in any of the industries he had studied. Even his favorite of Walter Annenberg’s “essentialities,” the Daily Racing Form, had become, for all practical purposes, toast.
Buffett would always love reading newspapers, but his investing was tightly focused on simple businesses that were as close to immortal as possible. Newspapers—in fact, any sort of media—no longer qualified. Candy, on the other hand, was an immortal business, and the economics of the candy business remained predictable.
In 2008, candy maker Mars, Inc. announced that it was buying Wm. Wrigley Jr. Company for $23 billion. Buffett agreed, through Berkshire, to lend $6.5 billion as part of the deal, in an arrangement facilitated by Byron Trott, his investment banker at Goldman Sachs. Trott had been responsible for several of Berkshire’s acquisitions. He understood how Buffett thought, and Buffett said that Trott had Berkshire’s interests at heart. Like many of Buffett’s investments, the Wrigley deal harkened back to his childhood, when he had refused to sell a single stick of gum to Virginia Macoubrie. “I’ve been conducting a seventy-year taste test,” Buffett said about Wrigley’s.
Buffett’s first thought after agreeing to make the loan—of course—had been to call Kelly Muchemore Broz and ask her to set aside a little space at the next shareholder meeting, in case Mars and Wrigley wanted to sell products to his shareholders. The 2008 meeting turned into a mini-festival of candy and chewing gum. Attendance set a new record: 31,000 people.
In another deal that year typical of Buffett, Berkshire acquired Marmon Holdings, a small industrial conglomerate with sales of $7 billion. The seller was Chicago’s Pritzker family, which had decided to break up its business to settle family squabbling that had broken out after the death of Buffett’s old coattailing hero Jay Pritzker in 1999.
Around this time, Buffett had also become more interested in the energy business, even though he had sold the PetroChina stock—for which he had recently taken a lot of heat, because when the price of crude oil peaked in July 2008 at $147 per barrel, six months after the sale, PetroChina’s stock kept rising. Buffett’s critics didn’t hesitate to speak up; he was accused of selling PetroChina too soon. Buffett said that he felt Berkshire had made enough money on the stock. What no one knew at the time was that Buffett was buying a huge slug—66.4 million shares—of ConocoPhillips stock. He was also increasing Berkshire’s stake in NRG Energy, Inc.
ConocoPhillips was the cheapest of the major energy stocks, and Buffett was concerned about inflation. Still, it was a surprising move at a time when complaints were proliferating that speculators were manipulating the energy market.
Buffett’s next move was equally counterintuitive. He wrote various derivative contracts for Berkshire that amounted to optimistic calls on the stock market in various economies. Some of these were direct bets on the market, and others were indirect bets that tied up some of Berkshire’s capital, rendering it unavailable in the event of a market crash.
The direct bets were “put options” on four stock indices—the Euro zone, the United States, the United Kingdom, and Japan—that would expire between 2019 and 2028. Berkshire would pay the buyers if any of the indices were lower at expiration than they had been when the puts were written. The total maximum exposure to these contracts (before taxes, and before $4.9 billion of premiums and the investment income they will earn) was $37.1 billion. Most likely, Berkshire would lose nothing, or a smaller amount. To lose the entire $37.1 billion, all four stock indices would have to fall to zero, in which case the world and whoever is running Berkshire at that time will have far bigger problems to worry about.
In deciding to insure investors against the risk that most of the world (except China) becomes insolvent, Buffett had handicapped the situation the way he would a catastrophe reinsurance contract—by assessing probabilities—and concluded that he liked the price compared to the risk Berkshire was taking. One curious aspect of these deals was their duration. Buffett had entered into contracts worth tens of billions of dollars, which would take up a chunk of Berkshire’s capital and whose value would not be known until he was between eighty-nine and ninety-eight years old. It was as if he had staked out a plot of capital within Berkshire, and leased it for this term. For the first time, he seemed to be acting on his determination to match Rose Blumkin’s lifespan.
This analysis of Buffett’s actions in recent years is constrained by close perspective and lack of hindsight; it is more akin to reporting and should be considered as such—in other words, more subject to revision than other portions of the book. However, it appears that Buffett, the ultimate capital allocator, did not fully understand how much capital he was committing to these deals. Buffett’s analysis excluded one other variable. Investors on the other side of Berkshire’s equity-index puts needed to hedge their credit risk on Berkshire. Buffett would later acknowledge (at the 2009 shareholders meeting) that he did not realize this. He thought of Berkshire, with its “Fort Knox” balance sheet and triple-A credit rating, as having essentially no credit risk, even though investors looked at it differently—quantitatively. If Berkshire could not pay for any reason, they would lose money. The investors bought credit default swaps (CDSs), a type of derivative that insures against credit risk, to make bets that would pay off if Berkshire stock fell.
The CDS price, or “swap spread,” is an indicator of a company’s bankruptcy risk. Stocks tend to trade in the reverse direction of their swap spreads. The CDS market has certain flaws, an important one being that a company’s bankruptcy risk grows as its stock price falls, and its stock price falls if its perceived bankruptcy risk rises. This self-reinforcing loop means that even companies with strong finances can find their balance sheets encumbered by perceived credit risk if their stock prices fall when their swap spreads rise.
Initially, this feedback loop did not seem important to Berkshire. Its stock price was approaching an all-time high; few people were paying attention to the puts; Berkshire’s balance sheet seemed impregnable.
Buffett’s sanguine attitude about the market, as displayed in the ConocoPhillips stock, the derivative deals, and his investing in a pair of Irish banks that were profiting from the booming—some said speculative—Irish economy, was all of a piece with another decision: to maintain large positions in certain stocks, especially financial stocks, but also in the rating agency Moody’s and in Coca-Cola, despite record stock valuations and signs of a bursting real estate bubble. In his mind, Buffett could clearly foresee the outlines of a potential financial meltdown. He explained how he wanted Berkshire to be positioned if that happened: “We want to be the lender of last resort.” Berkshire’s balance sheet made it, as Buffett always said, the “Fort Knox of capital.”
But it was as if he had never sat down and asked himself: What would Berkshire’s balance sheet look like if global stock markets fell by fifty percent? This would later prove an important omission.
Buffett had long preferred to find a great company and own the stock as long as possible. Investors who had watched him over the years had become so accustomed to certain Buffettisms—holding stocks for the equivalent of an investing lifetime, not selling businesses that Berkshire acquired, investing as though there were only twenty punches on your scorecard—that they believed Buffett’s investing style was to buy and hold forever.
Buffett had indeed learned through experience that “when in doubt keep holding”; he said, “I’ve made most of my money sitting on my ass.” He never sold failing businesses unless their economics turned from simply bad to parasitic, for personal reasons: He liked the people, the managers, the business, the simplicity of fewer decisions, and the reputation for loyalty.
Yet during his early, hungry years, he had not hesitated to sell one stock for another when a better opportunity came along. During the 1960s bubble, he moved money into staid AT&T, then shut down his investing partnership completely to protect his partners (and himself) from financial harm. During the 1987 bubble, with no partnership to liquidate and so much capital it had become a struggle to manage, he dumped many stocks in favor of bonds and pared the portfolio—but kept what he called the Inevitables (GEICO, Cap Cities, and the Washington Post). Still, by selling stocks, he had at least partly protected his shareholders from the second major market crash of his lifetime.10
In the 1990s, more passivity crept into his investing style. By then, Berkshire had far more money than it could use. During the Internet bubble, rather than sell overvalued stocks such as Coca-Cola (another of his Inevitables), Buffett diluted the risk from these stocks to Berkshire’s balance sheet by acquiring General Re.
With hindsight, he did say his failure to unload some of those stocks was a mistake. He explained that his role as a board member had gotten in the way of his selling Coca-Cola. Buffett finally stepped down from the board in February 2006, avoiding another referendum on his independence as a board member. Privately, Munger complained that Buffett should have resigned from the Coca-Cola board earlier so that they could have sold the stock. Selling would have pushed down the price, but not by as much as it eventually declined.
“I always used to tell Gates that a ham sandwich could run Coca-Cola. And it was a damn good thing, too, because we had a period there a couple of years ago where, if it hadn’t been that great of a business, it might not have survived.”
The company—and its stock—did rebound. By 2008, most of its business problems had been largely resolved, and CEO Neville Isdell, who announced his retirement in 2007, had settled the Justice Department investigation and closed a $200 million racial discrimination lawsuit. The new CEO, Muhtar Kent, had led the company’s successful push into non-cola drinks, where Coca-Cola had been lagging and was strategically off course.
Still, as of early 2008, Coca-Cola’s stock price, at $58, was fifty-six percent above its lowest price, but did not approach its pre-bubble high of more than $87 per share, and couldn’t justify Berkshire’s having held the stock for a decade. And it would soon turn out that Coca-Cola’s stock price was tracking the overall stock market, which would be revealed as part of another speculative bubble, this one buoyed by the ebullient “consumer economy” and driven by cheap credit. Although average wages in the United States had risen only 0.6 percent a year since 1998 and consumer confidence had been declining steadily, GDP had risen 2.6 percent a year. This was an artificial increase—boosted by an $8.6 trillion increase in personal indebtedness and an almost $20 trillion increase in household net worth—that came from rising real estate values and the stock market. In essence, consumer debt had inflated the economy beyond its real size. This economic “growth” was simply borrowed from the future, and would have to be paid back with interest.
The signs of a debt-inflated economy had emerged in the early “noughties” in the subprime lending and real estate markets. Wesco, led by Charlie Munger and with Buffett’s wholehearted concurrence, had considered adjustable rate mortgages as early as 1984, recognized the risks that were beginning to creep into the mortgage market from nonstandard terms, and kept its lending standards tight. Thus Wesco would not experience the sort of losses experienced by other mortgage lenders in 2007 through 2009.
By 2004, the giant government-backed mortgage lenders, Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae), had bought and guaranteed billions of these subprime mortgages. The Department of Housing and Urban Development required Fannie Mae to devote half its business to low- and moderate-income families, who borrowed through the type of aggressive loans that were fueling the subprime market. Easing the path to these loans, the Federal Reserve had slashed interest rates more than a dozen times and held rates at historically low levels for years. U.S. homeownership peaked at an all-time high of 69.2 percent. Housing prices grew at double-digit rates. Meanwhile, an inventory of unsold homes began to build in overheated markets such as south Florida and Las Vegas.
Berkshire Hathaway, which owned Home Services of America, the nation’s second largest real estate broker, collected these statistics, which Buffett monitored with concern. In late 2005 and early 2006, median home prices began to decline in certain areas, as the number of homes for sale rose and the amount of time they remained on the market lengthened. The U.S. home construction index had fallen forty percent by mid-August 2006. By early 2007, mortgage lenders had started setting aside more money for losses as delinquencies rose.
The first piece of serious fallout from the real estate bubble appeared in April 2007, when New Century Financial, the country’s largest subprime lender, filed for bankruptcy. Standard & Poor’s and Moody’s downgraded more than one hundred bonds backed by second-lien subprime mortgages.
As has so often happened with bubbles in the past, despite these ominous signs the Dow hit a new high of 14,000 in July 2007.
The global margin call began in August. Over a period of eight months, the financial world imploded in a credit crisis of historic proportions. Not since the Great Depression had such a severe credit seizure occurred. Not since the Panic of 1907, when old J. P. Morgan himself had personally intervened to orchestrate a solution to the panic, had such extraordinary informal intervention in financial markets taken place as would occur in 2008 and 2009.
The crisis progressed in fits and starts, with weeks and even months of apparent calm followed by shocking convulsions.
“They said all these derivatives made the world safer and spread the risk out. But it didn’t spread the risk in terms of how people reacted to a given stimulus. Now, you could argue that it might be way better to have that credit with just five banks, who could all work, than to have it with thousands around the globe, all of whom are going to rush out of it at the same time.”
The Federal Reserve cut interest rates once again, and worked with other central banks to activate other emergency sources of financing,11 yet the reluctance to lend began to show signs of contagion. On October 9, 2007, the Dow reached a high of 14,165, then went into free fall, as with one announcement after another of a huge loss from subprime loans, a fire sale, a bankruptcy, or a collapse, the low rumbling panic grew louder. More people tried to sell assets behind the scenes and found no buyers; more lenders began to call in loans. The CEOs of Merrill Lynch and Citigroup and the president of Morgan Stanley were ousted for subprime-related losses. Central banks began to take coordinated action to provide lending facilities to the major banks, because others were refusing to provide credit. This eased the financial distress temporarily.
MBIA and Ambac, insurers of mortgage-backed bonds, were downgraded by credit rating agencies for being seriously undercapitalized to bear the size of the losses that were emerging. Berkshire Hathaway formed its own bond insurer—Berkshire Hathaway Assurance Co.—to provide triple-A protection for sound municipal bonds that needed insurance. Buffett offered to buy $800 million of municipal bonds from MBIA and Ambac at what he thought was a rich price—$4.5 billion to each. They didn’t sell to Berkshire, and, as sizable municipal bond losses began to develop, he would later say he was glad the deal didn’t work out.
On Thursday, March 13, 2008, a bank run began on Bear Stearns, the weakest of the investment banks, as its lenders started refusing to roll over its loans. In a near re-creation of the Salomon crisis seventeen years earlier, Bear almost collapsed the following day, Friday, from lack of financing. Asked to bail out Bear, Buffett declined to pour money into a black hole, even for the company run by his old friends Jimmy Cayne and Ace Greenberg. Instead, the Federal Reserve took the unprecedented step of guaranteeing $30 billion of Bear Stearns debt—the first time the Fed had ever bailed out an investment bank. Bear closed at $30 per share on Friday afternoon. Buffett pondered the situation that evening. Long-Term Capital Management’s bailout had been a dress rehearsal—on a much smaller scale—for this moment.
“The speed with which fear can spread—nobody has to have an account at Bear Stearns, nobody has to lend them money. It’s a version of what I went through at Salomon, where you were just inches away all the time from, in effect, an electronic run on the bank. Banks can’t stand runs. The Federal Reserve hasn’t bailed out investment banks before, and that was what I was sort of pleading back there in 1991 with Salomon. If Salomon went, who knows what kind of dominoes would set off. I don’t have good answers to what the Fed should do. Some parts of the market are pretty close to paralyzed. They don’t want contagion to spread to what they would regard as otherwise sound institutions: If Bear fails and two minutes later people worry that Lehman fails, and two minutes after that they worry that Merrill will fail, and it spreads from there.”
The rational Buffett tried to unlock the puzzle embedded in the risky choices facing the Federal Reserve. It had no really good options. Either it allowed a financial meltdown or it took actions that would promote inflation by adding to downward pressure on the dollar.
“It could all end on a dime if they flooded the system with enough liquidity, but there are consequences to doing that. If dramatic enough, the consequences would be the immediate expectation of huge inflation. A lot of things would happen that you might not like. The economy is definitely tanking. It’s not my game, but if I had to bet one way or another—everybody else says a recession will be short and shallow, but I would say long and deep.
“You absolutely never want to be in a position where tomorrow morning you have to depend on the kindness of strangers in the financial world. I spent a lot of time thinking about that. I never want to have to come up with a billion dollars tomorrow morning. Well, a billion I could. But any significant amount. Because you just cannot be sure of anything. You have to think about things that have never happened before. You always want to have plenty of money around.”
All weekend the regulators and bankers toiled, much as they had years earlier on Salomon. This time, however, it was with the almost certain knowledge that the bank’s failure would have catastrophic consequences to the global financial system. Whether Bear Stearns deserved its fate was not at issue. Just before the Tokyo markets opened on Sunday, the Federal Reserve announced that it had orchestrated a sale of Bear to investment bank JP Morgan Chase for a pittance.
“It’s a weird time. We’ve gone into a different world, and nobody knows what will happen to the world, but Charlie and I looked at the downside, and nobody else did, very much.”
Deleveraging would be a painful process in which banks, hedge funds, financial-services companies, municipalities, the construction and travel industries, consumers, and indeed the whole economy withdrew—fast and painfully or slow and painfully—from the intoxicant of cheap debt. Asset returns could well stay subpar for a long time—what Charlie Munger called a “4 percent return world.”
In the midst of all the chaos of the spring of 2008, there sat Buffett, whose thinking about value and risk had not changed in the nearly sixty years of his career. There are always people who say that the rules have changed. But it only looks that way, he said, if the time horizon is too short. Buffett was stooping for cigar butts as if he were a child again.
“We’re selling some credit default swaps [insurance against firms going bankrupt] in situations where it is underpriced. I’m sitting here with my newest daily paper that I read, the Bond Buyer, on my lap. Who the hell would have thought that I’d be reading the Bond Buyer every day? The Bond Buyer costs $2,400 a year. I felt like asking for a daily subscription rate. We get these bid lists on failed auctions of tax-exempt money-market funds and other auction rate bonds and have been just picking them off. The same fund will trade at the same time on the same day from the same dealer at interest rates of 5.4 percent and 8.2 percent. Which is crazy, they’re the exact same thing, and the underlying loans are perfectly good. There is no reason why it should trade at 820, but we bid 820 and we may get one, while concurrently someone else buys exactly the same issue at 540. If you’d told me ten weeks ago I’d be doing this, I’d have said that’s about as likely as me becoming a male stripper. We’ve put $4 billion into this stuff. It’s the most dramatic thing I’ve seen in my life. If this is an efficient market, dictionaries will have to redefine ‘efficient.’ ”
In exchange for $3.4 billion of premiums, Buffett agreed that Berkshire would pay credit losses on certain companies with a value of $7.9 billion. Buffett would also use derivative contracts to insure municipal bonds at prices that appeared advantageous. Like the credit default swaps, both of these bets would pay off best for Berkshire in an optimistic economic scenario.
Win or lose, these were not things the average person should be doing.
“Stocks are the things to own over time. Productivity will increase and stocks will increase with it. There are only a few things you can do wrong. One is to buy or sell at the wrong time. Paying high fees is the other way to get killed. The best way to avoid both of these is to buy a low-cost index fund, and buy it over time. Be greedy when others are fearful, and fearful when others are greedy, but don’t think you can outsmart the market.
“If a cross-section of American industry is going to do well over time, then why try to pick the little beauties and think you can do better? Very few people should be active investors.”
If there is any lesson the life of Warren Buffett has shown, it is the truth of that.
By July 2008, regulators were forced to take other actions in attempts to save the mortgage lending companies Fannie Mae and Freddie Mac from sinking under the weight of the bad loans the government had insisted these companies make. Berkshire was asked to participate in private market bailouts of the mortgage giants, but Buffett suspected this would merely be—as his father might have put it—money down the rathole, and declined.
That same month, Buffett proved again that even though he could envision a financial tsunami with unusual clarity, he did not realize one was actually about to sweep over the world. He agreed to invest $3 billion for Berkshire in convertible preferred stock of Dow Chemical, to finance its merger with Rohm and Haas. The 8.5 percent dividend was modest compared to what Buffett had demanded in other such deals, and would appear paltry in hindsight.
By September, both Fannie Mae and Freddie Mac had failed and were placed under federal conservatorship. Meanwhile, several funds that invested in subprime mortgages also failed. Lehman Brothers put itself up for sale, and investors began betting against the stock, speculating that Lehman’s losses might be so heavy (or unquantifiable) that it might not find a buyer.
The weekend of September 13 and 14, in the domino sequence that Buffett had speculated might occur, Lehman continued to search frantically for a buyer, while Merrill Lynch, its stock price melting, struck a deal to sell itself to Bank of America rather than become the next Bear Stearns. Buffett took distress calls that weekend asking him to invest in various deals, among them syndicates to bail out or else buy pieces of insurance giant AIG, which had lost huge amounts on derivatives trades made by its financial products division. Buffett, who was always good at saying no, refused without hesitation, saying that while he couldn’t quantify how much money AIG needed, it was far more than Berkshire could supply.
Hanging over all of these stricken companies was the question: What is too big to fail? On Monday morning, September 15, the government delivered the answer. Lehman Brothers entered the largest bankruptcy filing in the history of the United States—$639 billion—after the Federal Reserve failed to organize a rescue for it. The next day the Fed injected an $85 billion emergency loan into AIG,* albeit on terms that amounted to a government takeover of one of the world’s largest insurers and essentially wiped out AIG’s equity holders.
Lehman, therefore, was not too big to fail, while AIG was. Yet Lehman’s financial entanglements were so enormous that they nearly took down the entire global financial system. Within days, the Reserve Primary Fund, one of the nation’s largest money market funds, failed because it was holding Lehman bonds. Reserve Primary could only pay investors ninety-seven cents on the dollar, setting off a panic in the credit markets and among retail investors by overturning the assumption that a dollar invested in a supposedly safe money market fund was sacrosanct and would always be worth a dollar. Lenders everywhere began to deny each other credit.
This was the nightmare that Buffett had envisioned at Salomon, writ larger because massive growth in the global derivatives market had increased systemic risk over the years. By Thursday, September 18, Morgan Stanley, as the presumed next victim, was trading at midday below $12 per share, versus the previous day’s close of $21.75; Goldman Sachs was sliding downward as the next potential casualty in line. The bankers blamed short-sellers, and this was where the government finally drew the line, asking for extraordinary new powers to create an emergency liquidity facility for investment banks that allowed them to convert to bank holding companies in order to access the government’s discount window, and issuing an unprecedented, and temporary, ban on short-selling numerous financial and other stocks.† This ban outraged hedge funds, and the SEC was immediately criticized for reducing liquidity and forcing investors to sell more stocks because they could not hedge their positions.
Some investment banks had approached Buffett for aid and were rejected because, he said, the terms weren’t rich enough. On September 23, Berkshire invested $5 billion in a preferred stock of Goldman Sachs that paid ten percent nominal interest and included warrants to buy $5 billion of stock for $115 per share. With part of the price assigned to the value of the warrants, the effective yield on the preferred was more than fifteen percent. This kind of loan-shark interest rate was, at last, what it took to get Buffett to open his wallet and give Goldman his imprimatur, which enabled the firm to raise another $2.5 billion in equity capital. The deal was so rich, he said later, that he couldn’t have gotten it a week earlier, or a week later.
Buffett had a longstanding, nostalgic, almost emotional attachment to Goldman, dating from the day his father took him to see Sidney Weinberg when he was ten years old; he liked its management; and, of course, his Goldman banker Byron Trott had helped Berkshire make a lot of money, which Buffett always found endearing. Still, it was astonishing to see Buffett, the critic of Wall Street, once again investing in a conflict-riddled investment bank after his experience with Salomon. The only differences were that he did not have to serve on the board—never again would he take on that responsibility—and that he had gotten better terms—in fact, even better terms than the government was getting on its bailouts.
Within days of Berkshire’s investment in Goldman, the House of Representatives rejected the Bush administration’s $700 billion bank bailout package. This, combined with the failure of thrift bank Washington Mutual—unprecedented in size—sent the Dow down 777.68 points to 10,365 on September 29, its largest one-day drop in history. Goldman stock swooned, and the blogosphere almost immediately began to call Buffett’s investment in Goldman a failure.
Days later, Buffett struck a similar deal with General Electric for both warrants to buy $3 billion worth of common stock, and $3 billion in a perpetual preferred stock, callable by GE within three years, which paid ten percent interest at a price of $22.25 per share. As with the Goldman deal, Buffett’s presence as an investor enabled GE to raise money from other investors. The extraordinary terms he could exact were the price of his reputation.
While Buffett was deal-making, he appeared on the television talk show Charlie Rose on October 1 to stress the need for confidence in the economy and urge Congress to pass the Treasury’s bailout bill. Buffett described the financial crisis as an “economic Pearl Harbor.” The following day, Congress reversed itself and signed the Emergency Economic Stabilization Act to make $700 billion in emergency funds available to the Treasury. Even if his views were not what had influenced lawmakers (he had the ear of some), Buffett’s calming words would soon be cited worldwide. His was probably the most influential expression of confidence during the crisis, at a time when hordes of politicians, pundits, and economists were opining in every possible medium.
Financial institutions were not the only casualties during this phase of the crisis. Another piece of fallout from the Lehman bankruptcy hit Constellation Energy, which saw its stock decline fifty-eight percent in three days. Constellation reached out to a number of parties seeking rescue; Berkshire’s MidAmerican Energy made an offer to buy the entire company for $4.7 billion and Constellation accepted. This offer was a classical Buffett no-lose deal: It was priced at less than half the market value of Constellation the previous week; MidAmerican also injected $1 billion of cash—at a fourteen percent interest rate—into Constellation to provide immediate liquidity, and Buffett locked in the deal with an onerous break-up fee. Whether Berkshire bought Constellation or not, it would make a hefty profit.
In December, EDF (Électricité de France SA) offered a far higher competing bid that would pay $4.5 billion for forty-nine percent of Constellation’s nuclear energy business. Constellation’s management fought to retain the deal with Berkshire, but was ultimately forced to merge with EDF. In exchange for the cancellation, MidAmerican harvested a $917 million gain on its $1 billion investment—plus a $175 million break-up fee.
Yet even this huge profit was smaller than the $2 billion or so that Berkshire netted in the fall and winter of 2008 from a series of casual trades Buffett made buying distressed corporate bonds. This type of investing was easy and automatic for him; he scanned the bond tables and made his choices based on a few mental calculations the way somebody else might fill out a Sudoku puzzle.
As he was picking off bonds, Buffett published a New York Times editorial, “Buy American: I Am,” in which he said that stocks were cheap enough and that while they might get cheaper, looking for the bottom is a fool’s game; that stocks are the best protection against inflation; and that he could be putting all his personal investments into the stock market within the next year. The Dow at the time was trading close to 8,900.* Some investors raced to follow Buffett’s advice, and rued doing so when the market soon fell below 7,000. Buffett, who rarely wrote editorials because he was mindful that people followed his lead, blamed the headline, saying, “I don’t write the headline.”
Investors debated Buffett’s sincerity, wondered whether he was grandstanding or genuine, trying to give the country his best opinion or being patriotic. He was accused, as a major owner of financial stocks, of “talking his book” by saying it was time to buy. It was certainly true that Berkshire and Buffett stood to benefit from higher stock prices, but Buffett never risked his reputation for mere money. He only went on the record with a prediction—of any kind—when the odds overwhelmingly favored his being proved right.
In the editorial, he cited inflation as a reason to buy stocks rather than take the risk of staying in cash. Inflation was his ace in the hole; over time, even if the economy did not do well, the nominal earnings of companies would increase significantly if inflation returned, and so would the prices of their stocks. His talk of inflation also shed some light on the economics of the equity-index puts. Even a modest amount of inflation stacked the odds in Berkshire’s favor, making it more likely that the indices would be higher at their expiration dates than when Buffett had struck the deals.
These were long-term considerations. For now, incredibly, Buffett—who for years had struggled with having too much money to invest—was out of cash. He had to sell some Johnson & Johnson and Procter & Gamble stock (reluctantly) in order to enter into the GE and Goldman deals. He also sold some ConocoPhillips stock, taking a loss. And Coca-Cola had once again declined to its old territory of $42 a share.
As the stock market fell, and prices of stocks like Coca-Cola, Wells Fargo, U.S. Bancorp, American Express, and Moody’s cut a slice into Berkshire’s book value, owners of the equity-index puts shorted Berkshire using its credit default swaps. Berkshire’s swap spread rose above 475 “basis points” (4.75 percent), several times higher than companies like Travelers and JP Morgan.
About a year after it reached its high price of $149,200, BRK traded between $90,000 and $78,000 per share—around, and at times even less than, its book value.* Unlike in 2000, however, Buffett did not offer to repurchase shares—probably because Berkshire was no longer flush with cash. Along with unrealized investment losses on stocks, Berkshire reported poor third-quarter earnings after hurricane losses in the insurance business and write-downs on derivative bets. The “cigar butt” credit default swaps that Buffett had written around the time Bear Stearns went under were not cigar butts after all. Buffett had turned out not to be skilled enough to price these derivatives with a sufficient margin of safety.
When Berkshire disclosed that Buffett had written these corporate credit and municipal derivatives, his widespread entry into this market confounded observers who thought of him as a critic of derivatives—Buffett had written in 2002 that they were “time bombs,” and in 2003 that they were “financial weapons of mass destruction.”
But Buffett had never been opposed to the use of derivatives. What he objected to was their almost nonexistent regulation, the lack of disclosure, and an entangled global web of counterparties who owed one another money and, because of opaque valuations, might not be able to pay when claims came due. Without disclosure or oversight, the system was riddled with incentives to overstate the value of derivatives.
Buffett felt he had protected Berkshire from these potential problems because Berkshire was generally getting paid to act as a guarantor—in other words, it would owe its counterparties if a loss occurred. This meant that Berkshire held the money rather than taking the risk that others would not pay. Furthermore, Buffett had declined deals that required Berkshire to put up significant collateral against payment if it appeared likely that a loss might occur in the future.12
But this distinction was lost on observers, who suspected Buffett of being a hypocrite for using the very derivatives that he had condemned: The statesman who used simple aphorisms to attack sophisticated financial techniques as chicanery ran into trouble when he tried to use these same techniques in a nuanced way to make money for Berkshire. Even some of Buffett’s most ardent supporters thought he should have left the derivatives alone if only for appearance’s sake—they were risky and complex, and made him look at best a heedless opportunist, and at worst naive yet still somehow duplicitous.
Above all, they had tied up Berkshire’s capital at a time when Buffett needed it.
Formerly, investors would have brushed this off on the assumption that Buffett was more or less infallible and Berkshire would profit in the long run. But some of Buffett’s errors seemed inexplicable—or at least he did not offer much of an explanation to the shareholders. The Irish banks had blown up, and ConocoPhillips would prove to be perhaps the worst stock investment, in total financial losses, that Buffett ever made. Meanwhile, the rating agencies, and prudence, now required Berkshire to maintain about a $25 billion cash cushion to support its insurance and other risks. It had become apparent that Berkshire was capital-constrained. And under pressure from the SEC, Buffett agreed to disclose more information about Berkshire’s derivative contracts.
Yet in the larger perspective, these troubles were trivial compared to those of most financial services companies. Buffett’s more important role—which he had performed magnificently—had been to protect his shareholders from the kind of leverage and uncontrolled risk that had so far brought down Bear Stearns, Lehman, AIG, Fannie, and Freddie; nearly destroyed Merrill Lynch; battered the Swiss banks; almost mortally wounded Morgan Stanley and Goldman Sachs, GE Capital and GMAC; crippled the bond insurers, the life insurers, and even the automakers; destroyed whole business models; and transformed the financial services business so dramatically that the full impact would probably not be understood for years.
Berkshire remained financially healthy, still the “Fort Knox” of capital, still able to invest on highway-robber terms when others were desperately seeking money, able to do deals like Constellation Energy and buy distressed bonds on the cheap. In the long history of Buffett’s career, having the foresight to avoid the risky financial instruments that felled so many other companies would rank among his greatest achievements.
It was ironic that, having protected Berkshire so carefully against derivatives by predicting that they would become “financial weapons of mass destruction,” even Buffett himself could not anticipate just how right he would be.
The financial crisis expanded late in 2008 and into 2009 with secondary bailouts of automakers (which, characteristically, Buffett showed no interest in participating in, saying understatedly that “whether they have a sustainable business model is open to question”) and massive, repeated intervention by central banks around the world. Credit-shocked consumers simply stopped spending money. “It was like a bell was rung,” as Buffett put it, sending the U.S. and global economies into a further spasm. Berkshire’s high-end retail businesses, especially Borsheim’s and NetJets, were most affected. The S&P 500 index closed the year down thirty-eight percent; BRK stock had fallen thirty-two percent.
The “bell-ringing” metaphor was apt for U.S. politics as well. In November 2008, voter outrage over the war in Iraq and the stalled economy gave the Democrats control of the White House for the first time in eight years, with a commanding majority in the House of Representatives and close to a filibuster-proof majority in the Senate.
Buffett’s role as a political player in this historic election had placed him in a quandary. For once, he was faced with two candidates who were “The Candidate”—politically fresh, running to overturn the established order, and charismatic. This had never happened to him before.
Buffett’s tendency to back charismatic candidates dated to the 1970s, but had perhaps reached its apogee in the California gubernatorial-recall election of 2004, when he became the first prominent figure to endorse the actor Arnold Schwarzenegger. His association with Schwarzenegger, the eventual winner, as an economic advisor gave Buffett a heady boost of association with Hollywood power that fed the star-struck side of his personality for at least two years.
Around that time, Senator Barack Obama had cited Buffett’s influence in his writing, and Buffett embraced him early in the exploratory stage of the 2008 Democratic primary campaign. Obama was smart and business-savvy, and had views congruent with Buffett’s politics; he came across to Buffett as coolheaded yet sincere. He was charismatic, and he was black. He was as perfect a version of “The Candidate” as could be imagined, from Buffett’s perspective. Few things could have pleased Buffett more than being associated with the first black president—until Hillary Clinton entered the Democratic primaries.
Clinton’s entry into the race presented Buffett with a number of problems. Buffett liked being connected to the Clinton family’s political star-power, which had endured through eight years of Republican rule. Buffett had a strong personal attraction to, bordering on a minor obsession with, the reserved Hillary Clinton. He had always been attracted to strong, intellectual women who might figuratively rap his wrist with a ruler if he got out of line; his mother certainly had that style, and he used the term “schoolmarmish” (affectionately) to describe certain women he liked, such as his friend Carol Loomis. Unlike most such women, Hillary Clinton, while friendly, had eluded his efforts to charm her, which made her all the more tantalizingly attractive to Buffett.
Buffett also had a genuinely warm relationship with Bill Clinton. And in seeking sponsors for his foundation, Bill Clinton had cultivated the budding philanthropist Susie Jr., which gave Susie Jr. an entrée into high political circles.
Now, faced with the quandary of saying no to one of two extremely popular candidates, both of whom he liked and who represented minorities, Buffett demurred. He declined to endorse either and said he would be happy if either candidate won. He raised funds for both candidates, giving priority to Clinton early in the race when she was the front-runner, then becoming evenhanded as Obama pulled ahead.
By staying on the sidelines, he had tried to maintain relationships and avoid unpleasant confrontation. He kept his options open to endorse the eventual nominee, Obama. This made some of Buffett’s friends grumble about what they considered self-serving calculation or moral cowardice, even though they knew Buffett was incapable of putting himself in a direct path of confrontation.
Because the primary campaign, in the end, was far more hotly contested than the election (which Obama won by a landslide), Buffett in the end wasted his endorsement by holding it back until it became irrelevant. As one observer put it, “Warren only ever wants to back winners. Your real friends are the people who are there for you even though it might cost them something.”
During the general election, both Republican candidate John McCain (a longtime friendly political ally of Buffett’s on some issues) and Barack Obama said in a debate that they would like Buffett to serve as treasury secretary. Buffett was now so widely seen in the public mind as a steadying influence on the economy that he had become a financial flag for both candidates to wrap around themselves. There was never the slightest chance Buffett would have taken any job that would require him to show up for scheduled meetings, and give up running Berkshire Hathaway. And while Obama might have liked to have Buffett as treasury secretary, Buffett’s lengthy withholding of his endorsement also appears to have cost him influence in the White House at a crucial time in American history. Obama had done Buffett a favor by crediting him as a sort of mentor before the campaign; then Buffett failed to reciprocate.
People tended to respond to Buffett’s withholding instincts in one of two ways. The more neurotic were stimulated to work harder, often fruitlessly, to win Buffett’s approval, favors, and enormous future possible boons that he dangled without necessarily granting.13 Others, once burned, made sure they were never in his debt and relied on him for nothing so that Buffett lacked anything to withhold. If possible, they arranged it so that Buffett needed something from them instead.
In the end, President Obama named Buffett an economic advisor and Buffett attended a ceremonial meeting—which helped the White House look economically astute—but by all outward signs, he had no special influence on or toehold in the administration.
As the financial crisis evolved, the lame-duck Bush administration and the new Obama administration followed a consistent course under Federal Reserve Chairman Benjamin Bernanke and Treasury Secretary Timothy Geithner, with the Fed injecting trillions of dollars into the U.S. banking system, trying to forestall deflation—chronic falling prices such as occurred in 1932. The still-unfolding crisis revealed its complex brew of causes, including artificially low interest rates, foolish borrowing by businesses and individuals, foolish lending by banks and investors, overreliance by institutions on complex financial instruments, aggressive behavior by derivatives traders, conflicts of interest at the banks being paid as agents to package loans sold to them by originators and resell them to investors, a climate of deregulation, lax oversight and enforcement by regulators, abdication of responsibility by rating agencies, inadequate capitalization of bond insurers, investor indifference—in other words, effects of all the normal dysfunctions that precipitate a bubble.
Of the responsible parties, it was the banks and AIG that earned the public’s greatest ire, while Buffett became the public’s greatest symbol of financial responsibility.
Treasury yields soon reached zero, but the flood of money failed to open the channels of business lending; credit remained virtually nonexistent. Buffett, who was at the time acting as the economy’s greatest cheerleader, lent at interest rates that in some instances bordered on usurious—$150 million of twelve percent notes in Sealed Air; $300 million of Harley-Davidson debt for a fifteen percent interest rate; $300 million of ten-percent contingent convertible senior notes from USG; $250 million of Tiffany bonds at ten percent; and a $2.7 billion, twelve-percent perpetual convertible stake in Swiss Re that would give Berkshire a thirty-percent ownership in the insurance giant.
This latter move baffled insurance industry insiders, including Swiss Re employees. Swiss Re was General Re’s biggest competitor; observers concluded that, on any terms, the investment to prop up Swiss Re made no sense because of its negative long-term strategic consequences to Berkshire—unless Buffett ultimately meant to take over Swiss Re and merge it with General Re. In the past, however, Buffett had made opportunistic insurance investments that worked against Berkshire’s long-term interests. Challenged on this, he would respond, “If we don’t do it, somebody else will.” Thus it was equally likely that there was no strategy whatsoever behind the deal besides extracting some fast cash from the pockets of the Swiss.
Throughout, Buffett became an even more frequent presence on CNBC and other networks. He filled the role of America’s statesman and father figure during the financial crisis, but he had also fallen into the trap of competing for attention instead of trusting that his sterling record would bring it to him. “Dignity, Warren, dignity,” counseled one of his friends—but Buffett had never wanted to be dignified; he had never minded looking silly if it would get people to pay attention to him. He was a performer and a showman, and now he feared the show might end. He would keep on giving as many performances as possible while there was time. And indeed, his profile grew and grew in proportion to how often he appeared on the magic medium of television.
All this was not only personally effective—Buffett was his own best publicist—but also understandable for someone his age, until his marathon performances on CNBC resulted in some serious gaffes: criticizing newly elected President Obama’s performance, giving advice to the White House (the Shoe Button Complex, something that Buffett had heretofore spent a lifetime avoiding), and a claim that he, like everyone else, had thought housing prices could only go up—an absurdity that raised eyebrows.
When Berkshire finally reported its 2008 earnings, the consequences of some of Buffett’s earlier decisions became even clearer. The insurance businesses had suffered large losses from that year’s unusually active hurricane season. “Last year was a bad year for a float business,” Munger would later say at the shareholder meeting, citing GEICO and the energy and utility businesses as bright spots. Although Buffett referred to Berkshire’s “Gibraltar-like” balance sheet, the erosion in its financial strength was unmistakable. Because of Berkshire’s heavy insurance exposure and its concentration in financial stocks such as American Express, Wells Fargo, and U.S. Bancorp, its book value was down by 9.6 percent—only the second decrease in its history (and the largest). Berkshire had recorded $14.6 billion of accounting losses on its derivative contracts. While many of these losses would probably be reversed in the long run, they had a significant impact on the balance sheet. Nearly all of the decline was due to bets on financial assets that were market-dependent.
Even so, the decrease in Berkshire’s book value was insignificant compared to major banks and nonbank lenders, which were technically insolvent or close to it, and receiving hundreds of billions in government aid. Buffett had steered Berkshire to a stellar performance, by that measure. All the work of many years had culminated in this moment: Berkshire standing alone after other businesses crumbled around it.
You would not know this by reading some of the commentary on Buffett. One of his challenges at this late stage of his long career was that he tended to be measured by some observers and journalists against a standard of perfection, as if he had to be infallible to be any good at all.14 Bloggers and financial writers went wild writing about Buffett’s derivatives exposure. Buffett went on the counterattack. That year’s shareholder letter contained a lengthy explanation of his reasoning for selling the equity-index puts. Yet by some calculations, under various scenarios Berkshire could indeed lose billions at the expiration dates of these contracts, which were not as well priced as Buffett had apparently thought when he entered into them. Ultimately, the concentration of financial assets and their effect on Berkshire’s value was significant enough that first Fitch Ratings, then Moody’s, downgraded the credit ratings of Berkshire and its subsidiaries (such as National Indemnity and MidAmerican) by one notch, from AAA or the equivalent.
The top rating had given Berkshire a lower cost of funding and significant advantages in its insurance business, which made it attractive to sellers of businesses. Buffett had displayed quiet satisfaction when Berkshire’s two largest insurance competitors lost their triple-A ratings, and had at times said privately that the one thing he would never do was jeopardize Berkshire’s triple-A, which he considered one of its most precious assets. In his shareholder letters, he liked to comment that Berkshire was one of only “seven,” or whatever the dwindling number was, of the remaining triple-A companies. He considered it unlikely that this rating, once lost, would be reinstated.
Now Berkshire had suffered that blow, which it probably could have avoided by raising (expensive) equity capital, something Buffett chose not to do. At the 2009 shareholder meeting, he downplayed the consequences. He said the derivatives did not impinge on capital and that a triple-A rating only conveyed “bragging rights.” “We’re still a triple-A in my mind,” he said. It was actually possible that Berkshire—in its uniqueness—could get the rating reinstated, but if so, it would be expensive even if Berkshire did not have to raise capital: It would have to reduce its exposures to insurance and equity market risk as a percentage of book value. Buffett probably would choose not to pay that price because its benefit was limited; no other financial institution remained with a triple-A rating.
Thus, the real meaning of the downgrade, in a larger context, was that the crisis had unveiled the true risk inherent in the global financial system—and the rating agencies had responded by increasing the capital threshold for a triple-A rating to a level that meant even the soundest institution found it financially unattractive to qualify.
Buffett also revealed at the 2009 shareholder meeting that to reduce Berkshire’s derivative risk, he had renegotiated two of the equity-index put contracts, shortening the terms by eight years in order to lower the price at which Berkshire would have to pay out losses. By then, the values of Wells Fargo, U.S. Bancorp, and American Express had begun to recover, but Wells and U.S. Bancorp had cut their dividends, which would also affect Berkshire’s future earnings. Buffett predicted that Wells Fargo would not have to issue stock, a prediction that was almost immediately contradicted when Wells Fargo did just that. He scored better a few weeks later when Berkshire’s SEC filings revealed that he had been buying American Express while the stock was on its back.
Thus, during the financial crisis, Buffett made a series of characteristic brilliant moves interspersed with some surprising errors. Above all, he stood pat on existing investments while adding cleverly structured new deals, deals that for the most part were not available to ordinary investors. These opportunities came to Berkshire because of its ready cash and underlying financial strength, and because of Buffett’s willingness to rent his well-earned reputation and provide quick, trustworthy handshake dealmaking.
The actions he had taken with deals struck in 2008 and 2009, in accordance with his saying “Cash combined with courage in a crisis is priceless,” would enrich Berkshire shareholders for many years to come. At the same time, the crisis—which admittedly had so many episodes of heart-stopping disintegration into near economic collapse that in some ways it eclipsed the events leading to the Great Depression—left Berkshire a weaker company financially. It undercut Buffett’s reputation as a nearly infallible manager, and cost the company its top financial rating.
The 2009 shareholder meeting would prove to be both a celebration of Berkshire’s success and a chance for Buffett to defend himself. He had changed the meeting format so that half the questions would concern Berkshire and would be submitted through a panel of journalists: Carol Loomis, Becky Quick of CNBC, and Andrew Ross Sorkin of the New York Times. A torrent of five thousand questions poured in, many of them tough-minded queries from people who wanted answers but who had not, in the past, been willing to wait hours for a position at the microphone while others asked Buffett about his personal relationship with Jesus Christ and what books he and Munger had read lately.
The new format and the unsteady economy attracted what was said to be a record thirty-five thousand people in attendance despite Berkshire’s stock price, which hovered at $90,000 per share. Buffett, who never said anything spontaneous, always seemed to have an answer prepared for every question that could be anticipated. The main difference in 2009 was that shareholders were asking truly challenging questions, rather than flattering him with their gratitude for being able to stand in his presence and receive his wisdom. At his most impressive he rattled off statistics and explained economics with a clarity that people were not hearing from anyone else. But his answers on other questions were more awkward. Buffett liked to deal with confrontation indirectly. Put on the spot, he behaved as he did in private, avoiding direct answers to some questions and meting out unpleasant information through hints and sometimes by omission.
Challenged on his decision not to sell financial stocks in the spring of 2008, he said he only sold when a company’s competitive advantage disappeared, he lost faith in management, or he needed cash. He was cutting a fine distinction in trying to separate his criteria for selling stocks when companies’ circumstances were changing materially all the time, versus selling whole businesses, which happened only when they became economically unviable or had persistent labor problems. With newspapers folding in cities all over the United States, he also went so far as to raise the possibility of eventually shuttering the Buffalo News, but said that as long as the News made a little money and had no labor problems, he and Munger would “keep it going.”
Buffett was questioned sharply about why he did not sell Moody’s when its business model was fundamentally compromised after the rating agencies were implicated in causing the financial crisis. He said he thought the odds were that Moody’s was still a good business, and that he did not think conflict of interest—rating agencies are paid by the entities they rate—was “the major cause” of the problem. (Another conflict of interest, not mentioned, was Berkshire’s twenty-percent ownership of Moody’s when Moody’s rated Berkshire.) Many in the audience had spent years listening to Charlie Munger’s often repeated saying, “whose bread I eat, his song I sing,” and understood that Buffett was rationalizing as he always did in pursuit of a profit or when he felt backed into a corner—or both.
When Buffett was asked how the four investment managers he had chosen as possible replacements performed during the 2008 market crash, and whether they were still on the list of candidates, he said they “didn’t cover themselves with glory,” then commented that neither did most investment managers during this period. Buffett did not respond to how these managers did relative to the market or to their relevant benchmarks. He left a vague impression that the list of candidates might change, over time.
What was certain, whichever candidates were chosen, was that the stock market would eventually recover. More important were Berkshire’s businesses. Most were among the best in their respective industries. Buffett had built a conglomerate of stable businesses that were likely to be profitable for a long time. Still, the events of 2008 had certainly convinced many shareholders that Berkshire was not a company that could be run by a ham sandwich after Buffett was gone.
At the meeting they grilled Buffett about the question of succession with new intensity. The next CEO’s challenges would be keeping Berkshire’s managers happy, managing the company’s franchise and risks, and investing the cash flow the businesses threw off. Buffett insisted that all the candidates were internal. He said that running a major operating business was the best qualification for the CEO job. He next talked about what he actually did as CEO, which did not involve anything remotely resembling running an operating business (nor had Buffett ever run an operating business; nor could he have, had he been forced to do so).15 He stated that the operating managers had experience allocating capital—perhaps a necessary rationalization, although nobody truly allocated capital at Berkshire other than Buffett, particularly not in financial services, the heart of the company and the site of Berkshire’s recent woes.
The answer revealed that Buffett was publicly introducing a rationale to pave the way for someone like David Sokol, the presumed front-runner who ran MidAmerican Energy. Buffett was also using a selection process that in some ways mirrored his two disastrous experiences at Coca-Cola, one that could someday put the board in an awkward spot.
To be sure, Buffett had already divided executive authority in a way that many outside candidates would not find comfortable—with his son Howie succeeding him as chairman, and Bill Gates taking on the role of de facto lead board member as representative of Berkshire’s largest future shareholder, the Bill and Melinda Gates Foundation. This meant that, for better or worse, Berkshire probably would always be run in an unusual manner by unusual people.
The unusual company that Buffett—or Sokol, or possibly even a committee—would be running was stable and successful, and had, because of the financial crisis, gained relative advantage over its rivals in many of the businesses in which it operated, even though as of spring 2009 its results and financial condition also reflected the weakened economy.
As for the future, Buffett said retailing, especially of luxury products, might not recover for years. Companies like Borsheim’s and NetJets were going to struggle. He said little more about NetJets; the sparsely populated aisles at Borsheim’s on Sunday after the meeting spoke for themselves. On a brighter note, he said that new household formation was the key to recovery of housing-related sales, with 1.3 million new households formed in the United States every year.
He spoke optimistically of the long-term future of the U.S. economy, which had survived two world wars, many panics and depressions, the resignation of a president in disgrace, and civil unrest. At various times, he had discussed what he expected to be inevitable inflation and the declining value of the dollar. Yet it was the “unleashed potential” of the human race that caused economies to grow over time, he said; in other words, productivity. The world’s system to increase productivity works naturally and has been working for a long time. Munger waxed enthusiastic over Berkshire’s investment in BYD, a Chinese maker of electric cars. We are about to harness the power of the sun, he said, and use more electric energy to preserve hydrocarbon energy for chemicals that are more important. The main technical problem of mankind is about to be fixed, he opined.
Then he and Munger headed off to meet with the international shareholders, and Buffett and Astrid attended another round of parties on Saturday night.
Within days, Buffett would begin planning the 2010 meeting—when he would be almost eighty. He couldn’t believe he would be eighty. Every year he attacked the meeting planning as though this year would be his ultimate statement—his greatest show on earth. In 2009, he had shown off an electric car. He would have to find some way to top that in 2010.
Meanwhile, to his slight chagrin, Borsheim’s had missed out on one sale in 2009. (Every sale mattered to Buffett.) At 3:00 p.m. during the shareholder meeting, “Alex from Boston” asked Buffett what individuals could do to help the economy. Buffett said, first, to spend money, then repeated that new household formation would be helpful to the economy. With that, “Alex from Boston,” who was Buffett’s grandnephew Alex Buffett Rozek, asked his girlfriend Mimi Krueger to marry him. Mimi, stunned to be asked in front of thousands of people, said yes, and Alex gave her his grandmother Doris’s sapphire-and-diamond ring, which Warren had given his sister for her seventy-fifth birthday.
Buffett the showman had always wanted to have a wedding at the Berkshire shareholder meeting, but had never quite managed to pull that off. He would settle for an engagement instead.
*Before working on Wall Street, I was one of those trying to rein it in, as a project manager at the Financial Accounting Standards Board, the primary accounting rulemaker. I helped to draft rules that specify how to account for finite reinsurance.
*I was subpoenaed by the prosecution as both a fact witness and an expert, and testified as an analyst that I would “almost certainly” have not upgraded AIG to a “strong buy” in early 2000 had I known the company’s true financial position. Under cross-examination I testified about my acquaintance with all of the defendants. I know some of them better than I do others, but have always had high regard for all of them. I also testified about my relationship with Warren, that I was writing this book, and that Joe Brandon has been a close friend since 1992. I wasn’t asked about Tad Montross, but I’m also acquainted with him.
*Currently I am still under subpoena from former AIG CEO Hank Greenberg in a related case brought against him by the New York Attorney General’s office. And at this writing, Berkshire Hathaway has settled with neither the SEC nor the Department of Justice.
*Which would later grow to $186 billion.
† I am, at the time of this writing, a senior advisor to Morgan Stanley and owner of Morgan Stanley stock.
*It shortly declined below that level and remained there for months, dipping to as low as 6,547 on March 9, 2009.
*While writing The Snowball, I never owned Berkshire stock, but I bought some after the book was published and the stock had collapsed.